• Bonuses – for Good or Ill?

    Eyebrows and ire were both raised by last week’s reports of the huge bonuses – contributing to even bigger remuneration packages – paid out to the executives of some of our leading companies, even when those companies had seen profit margins fall substantially. Nothing more strongly suggests that the lessons that seemed such a clear legacy of the global financial meltdown just a few brief months ago have been quickly and conveniently forgotten.

    Even the justification offered by the spokesman for the Institute of Directors was redolent of a distinctly pre-recession complacency. “If we are to attract the talent we need,” he solemnly intoned, “we have to pay salaries to match those paid in the rest of the world.” It’s a wonderful thing, the global economy; it requires us to push up New Zealand’s top salaries in an attempt to match world levels, but at the same time requires wages for ordinary employees to be driven down to the benchmarks set by the lowest-wage economies.

    The supposed need to pay a top executive 100 times the income of his skilled employees is a self-serving nonsense produced by a small charmed circle who claim the right to set their own (and their mates’) pay rates. But the bonus culture which seems to have emerged unscathed from the recession is objectionable, not just because it produces scandalous inequities in terms of total remuneration, but because it is seriously deficient as a means of producing better economic performance.

    The payment of very large “performance” bonuses is, we should note, a feature of a peculiarly Anglo-American business culture whose quasi-religious faith in the infallibility of market forces should surely have been dealt a major blow by the implosion of the last year or so. But the case against it rests on sound principle and practice rather than ideological preference.

    I have had personal experience from both sides, as an executive and a director, of performance bonus schemes. On the basis of that experience, I believe that they promote attitudes that are the very antithesis of those we need.

    The theory is that, if executives have “skin in the game” (or any of the other macho phrases used to justify the practice), they will try harder and produce a better performance. The reality is, however, that bonus schemes encourage the very deficiencies which have bedevilled our economic performance over a long period.

    First, they engender a focus on the short-term at the expense of the longer-term health of the enterprise. “Short-termism” is a well recognised affliction of Anglo-American economies; it leads to cost-cutting and profit-taking over a short time horizon as alternatives to what we really need – investment, building new capacity, productivity improvements and strategic perspectives.

    Secondly, bonus schemes often distort performance, diverting attention from the issues that should really be addressed in favour of those which happen to be relevant to the bonus. Because many of the factors that determine a company’s performance are beyond the capacity of an individual executive to influence – macro-economic conditions are the most obvious example – they either have to be discounted, or applied even though it is clearly irrational to do so.

    The result is that boards usually either make a broad judgment as to what constitutes good performance in given circumstances, without reference to the factors (like a recession) that have really determined performance, thereby destroying the fiction that performance evaluation is based on measurable and accurate data, or they substitute for their own judgment a set of criteria which at least have the merit of being measurable, even if they are seriously irrelevant.

    If they take the first course, the “performance” that is allegedly being measured all too often becomes nothing more than a reflection of whether or not the board feels strong enough to risk alienating the executive by withholding a bonus or part of it. That seems to have been the story of the bonuses reported here over the past week or so.

    If they take the second course, and pretend to be measuring performance accurately according to quantitative criteria, the danger is that the executive focuses on the bonus criteria, even if they are barely relevant to any sensible judgment of good performance.

    The issue of whether or not a bonus is paid, and how much, can also be destructive of a good relationship between governance and management. Some boards will purport to be able to measure performance to the last percentage point. An executive who has done well may well feel cheated if the board says that only 75% of a bonus is to be paid. And if the bonus scheme extends to a larger group of executives, the issue of who gets what percentage of bonuses (bearing in mind that such information rarely stays confidential) can engender feelings of resentment and unfairness – hardly conducive to good human resource management.

    There is a much better practice, to be found in better-run economies than our own, which we should emulate. Top executives should be paid a proper rate for the job (and I have no objection to high salaries per se) on the assumption that, having been appointed, they will deliver a satisfactory performance. A less than satisfactory performance should be dealt with as a performance issue. An exceptional performance – above and beyond the call of duty – should be rewarded with a genuine, but one-off, bonus.

    This would require many employment contracts to be re-negotiated, not necessarily with a view to bringing total remuneration down, but with the aim of removing many of the deleterious effects of the current practice, and producing more transparent and defensible arrangements. It is up to boards (and shareholders) to take this more sensible approach.

    Bryan Gould

    30 August 2009

    This article was published in the New Zealand Herald on 3 September, and an amended version appeared in the online Guardian on 5 September.